Debunking The Velocity Myth Once And For All

At TDV we demonstrate this truth almost every day - in our blog, our tweets,
and in our newsletters.

Just last week Jeff
discussed the fallacy of GDP, comparing our lot to that of Jim Carey's
as Truman Burbank, the unaware mark in the Truman Show. In that blog,
Jeff discussed one of the main problems with relying on GDP (Gross
Domestic Product) as a measure of economic growth.

He reminded us of how the government manipulates this number - by inflating
the money supply and massaging the price data - since GDP is basically just
the sum of the monetary values of various goods (mostly consumption) adjusted
for the government's own hedonically massaged price deflator.

But that is just the tip of the iceberg.

You just can't fit these types of things into models and equations, even if
your intent was honest.

James Grant highlights the overwhelming problem neatly, "Imagine deciding
which nation produces what in a global supply chain. Or correcting price
for quality improvements. The mind boggles."

Yet that still just deals with the practical aspect of the calculation.

Consider the theoretical equation for GDP: C+G+I+X-M

I can't tell you how many hours I used to waste going over the income accounts
to make sense of the moving parts of "the economy" as a young stockbroker.
Not once did I ever stop to wonder, what exactly the government (G) ADDS to
the equation. I took it at face value. I've always known that it has no original
wealth of its own, and that it cannot create wealth; it just never occurred
to me in those years to question an equation that was taught to me in a formal
school...sanctioned by government!

Only once I took the Rothbardian red pill could I begin to see through the
fake sky painted on the ceiling. But it still takes a lot of thinking and questioning
to see well beyond it.

Another problem with the GDP framework, for example, besides overweighting
consumer spending relative to capital/investment spending, is that it has only
two dimensions: that is, it is either growing or not. It does not allow us
to distinguish between sound or lasting growth - where the pool of savings
is being invested wisely in the formation of new capital that increases our
productivity and real wages - and unsound growth - where savings are consumed,
and part of the existing capital structure and labor is misallocated towards
unprofitable ends (financed not by savings but by fractional reserves) so that
a crisis and/or bust becomes inevitable when the stimulus from the monetary
policy is withdrawn.

The bust allows the bad investments to clear (liquidate) and savings to replenish,
and for the patterns of production and consumption to return to a sustainable
balance, which essentially means reforming around society's needs, rather than
the central planners'. A boom built on the back of unsound credit is on shaky
ground because actual saving does not back it. It is nothing but a consumption
binge that expenses savings, and hence any lasting capital and wealth formation...i.e.
things that tend to support a rising standard of living. Increasing consumption
does NOT cause growth; it is a product of growth.

The entire idea of the GDP statistic is incoherent. Aggregating different
goods (apples and oranges) into one homogenous two-dimensional lump of shit
is no way to look at an economy full of individuals.

Likewise, there is no such thing as an average price.

These are abstract concepts, and even their creators warned of their many
flaws.

GDP is really nothing but a neo-Keynesian relic created for war time planning.

And yet, many investors wait with bated breath for wall street's estimates
of the government's figures, so they know it is safe to keep buying stocks.
The figure is expanding, all is okay, government says.

I can write pages and it would still just be the tip of the iceberg.

So much of the data that money managers think is important is really not.

It takes entire careers just to figure that out.

But, one of my all time biggest pet peeves in this business besides "the deflation" is
the concept of "velocity", which is not unrelated. In fact, it is thought of
as part of the reason and fix for deflation.

"Velocity Of Money In The U.S. Falls To An All-Time Record Low"!!

"When an economy is healthy, there is lots of buying and selling and
money tends to move around quite rapidly. Unfortunately, the U.S. economy
is the exact opposite of that right now. In fact, as I will document below,
the velocity of M2 has fallen to an all-time record low.

This is a very powerful indicator that we have entered a deflationary
era, and the Federal Reserve has been attempting to combat
this by absolutely flooding the financial system with more money. This
has created some absolutely massive financial bubbles, but it has not
fixed what is fundamentally wrong with our economy. On a very basic level,the
amount of economic activity that we are witnessing is not
anywhere near where it should be and the flow of money through our economy
is very stagnant." Click
the link to see the full article

I've emphasized the problematic or erroneous statements.

This week, in reaction to a similar analysis in Europe, the ECB decided to
penalize banks for maintaining excess reserves by charging 10 basis points
on any balances kept with it, incentivizing a flood of lending by the European
banks. This is known as a negative interest rate policy.

It is the opposite of what the Fed has done.

The Fed is paying interest on reserves; the ECB is now charging interest.

Banking analysts believe that despite previous attempts at QE by both the
ECB and the Fed, the commercial banks aren't pyramiding on their freshly printed
reserves. Instead they are sitting on them, and this is causing the central
planners great pain because they want to boost spending.

The problem - which is more perceived than real in the first place - is the
low velocity.

Of course, the ECB is acting as though it didn't realize the sky was just
part of the ceiling in Truman's world. For, as you now know, "the amount" of
economic activity is unimportant in the scheme of things. A healthy economy
does not require an unsound bank credit expansion to stimulate it.

And interest rates are supposed to be more than just a lever that gooses lending
and spending.

As Robert Murphy put it recently, "interest
rates coordinate production and consumption decisions over time. They do
a lot more than simply regulate how much people spend in the present." Hence,
when it comes down to it, this type of policy is, on the one hand, nothing
but papering over the actual problems, and on the other hand, it is one of
the key contributors to the existence of those problems.

What is the Velocity of Circulation?

It is often the semi-sophisticated person to use this phrase.

In fact, even some Austrian economists will tend to use the term -though unfortunately
they can't hear me jumping up and down and screaming at them through my computer
when they do. The odd thing about this though is that the Austrian school has
rebuked the theory countless times. Ludwig von Mises has dealt with it. Henry
Hazlitt has dealt with it. Shostak has dealt with it. I'm sure Block and Rothbard
have as well. I too have dealt with it in the past, though here I hope to explode
it entirely!

"Velocity" is simply the GDP divided by the money supply.

Like all bad things, it comes from this Irving Fisher equation for "the economy",

Although, to be fair, Fisher didn't invent the concept. He only revived it,
all the while ignoring the insights of the Mengarian contribution to subjective
value theory at the turn of the 20th century.

Originally the concept came about as an explanation for the variation in the
effects of increasing money quantities on prices. The quantity theory of money
was originally "mechanistic" in that its proponents would argue that an "X" percentage
increase in money would produce a proportionate increase in the price level.
Since in the real world humans are the intermediaries through whom the technocrats
are constantly trying to transmit price increases, and their actions
tend to be subjective, prices tend not to be proportionate. The original explanation
for this was thought to be velocity.

But it has since been shown to be misleading and irrelevant.

In a nutshell, the fallacies involved here are as follows,

can't separate T and V; and V is the dependent variable

velocity is an effect not a cause -doesn't 'cause' anything

a poor substitute for the concept of the demand for money

money does not actually circulate, nor is that an economic driving force

lacks a consistent directional relationship with prices

Demand for Money, Not V

The economics profession, guided by people like Irving Fisher, tended to ignore
the contributions of the Austrian School at the time, including their work
on the subjective
theory of value.

I still find that people automatically fall back into the classical trap on
value -where they assume that the value of a good is determined by the sum
of its costs to production plus some arbitrary amount representing the productivity
of capital (for interest).

But for the most part economists have come to accept the precept that the
value of a good is determined by the supply and demand for it on the free market
irrespective of what it costs to make, and that the factors (costs) of production
are derivative to the value of the good.

Mises applied this insight to monetary theory, ultimately explaining that
money too is a good, and that its value is subjectively determined by the judgments
of individuals...that a demand for money meant the demand to hold or acquire
cash balances...as a store of purchasing power. This made velocity obsolete
because it was quickly seen that fluctuations in the demand for money explained
its turnover.

A NY Times and WSJ journalist way back in the day named Henry Hazlitt picked
up on Mises and the rebirth of the Austrian School under Mises in the early
part of the 20th century. Hazlitt put together a wonderful piece
that I discovered here, where he
argued that changes in the demand for money over time, and not velocity,
explain variations in the effects of changes in money supply on prices in general.
This explained why prices did not change in proportion to money supply changes.
Murray Rothbard later expanded on the various types of the "demand for money."

The foremost type regards the intensity of trade "T" in the formula above.
If I want to buy a car, I am expressing a demand for that car. But the seller
of the car is expressing a demand for my cash.

The more exchanges, the more expressions of a demand for money. The two are
two sides of the same coin. They are inseparable to be sure. But there are
other types of demand expressions that come into play, including the kind that
is affected by inflation and deflation expectations. At any rate, changes in
prices and other economic factors can now be more accurately (and better) explained
by changes in the intensity of the demand for money than they could by changes
in its circulation velocity.

Money Never Circulates

There is no flow or circulation. In most transactions the sum of money involved
is never actually mobilized, only the title to its ownership changes. Regardless
of how high that statistic climbs, money spends the vast majority of its time
in the form of someone's cash holdings or balances - neither in motion nor
exactly idle, but rather, always ready to be used. That is its purpose, as
Mises put it,

"The service that money renders does not consist in its turnover. It
consists in its being ready in cash holdings for any future use. The main
deficiency of the velocity of circulation concept is that it does not start
from the actions of individuals but looks at the problem from the angle
of the whole economic system. This concept in itself is a vicious mode
of approaching the problem of prices and purchasing power. It is assumed
that, other things being equal, prices must change in proportion to the
changes occurring in the total supply of money available."

Velocity is a Statistic, It Cannot CAUSE Anything

"What we have to deal with, in the so-called circulation of money, is
the exchange of money against goods. Therefore V and T cannot be separated.
Insofar as there is a causal relation, it is the volume of trade which
determines the velocity of circulation of money rather than the other way
around... the velocity of circulation of money is, so to speak, merely
the velocity of circulation of goods & services looked at from the
other side. If the volume of trade increases, the velocity of circulation
of money, other things being equal, must increase, and vice versa."

Changes in the velocity of circulation are clearly the effect, and not the
cause, of changes in the demand for money and/or goods. The statistic has no
more bearing on the value of money (its purchasing power) than the concept
of "inventory turnover" has on the price of the individual units of inventory.
If trade is on the rise, circulation (velocity) must rise. Individuals are
expressing a demand for money in selling their wares, and the less there is,
the more it must circulate or turnover.

"People who are more eager to buy goods, or more eager to get rid of
money, will buy faster or sooner. But this will mean that V increases,
when it does increase, because the relative value of money is falling or
is expected to fall. It will not mean that the value of money is falling,
or prices of goods rising, because V has increased... It is the changed
valuation by individuals of either goods or money or both that causes the
increased velocity of circulation as well as the price rise. The increased
velocity of circulation, in other words, is largely a passive factor in
the situation." ~ Hazlitt

No Consistent Relation Between Velocity and Prices

Hazlitt found that velocity would vary with the intensity of speculation on
Wall Street and other financial centers. There was no directional significance.
Sometimes it would increase with falling prices. Other times with rising prices.
The same occurs in consumption in its relation to general purchasing power.

An increase in the volume of trade, for example, represents an increase in
the demand for money, which tends to result in an increase in velocity. But
here the pressure would be on prices to fall.

On the other hand, a reduction in the demand for money caused by inflation
fears will tend to increase velocity but put pressure on prices to rise. And
vice versa. An increase in the demand for money due to deflation fears can
cause prices to fall and decrease velocity while a decline in the demand for
money due to a fall in trade might see prices higher depending on other factors
while velocity declines.

So it is ignorant to simply state that higher velocity causes higher price
inflation and vice versa.

It is equally ignorant to presuppose that economic health depends on spending,
lending or velocity.

Conclusion

One of the main causes of the decline in this statistic is simple to explain.

Money growth has outpaced the growth of GDP for over a decade so that the
denominator in the calculation of "V" continues to grow.

Another plausible explanation, at least prior to the past 18 months, was the
hoarding of cash that seemed evident broadly.

But the causes for the decline in V do not matter.

The decline itself does not matter.

However, a policy intent on stimulating this variable is just as misguided
as a policy that is directed at increasing "the amount" of wasteful economic
activity at the expense of real prosperity.

There is no doubt that the ECB policy will work to increase lending and money
growth, as well as intensify inflation expectations. This will reduce the demand
for money, which may or may not result in an increase in V depending on other
factors, but it is sure to bring about a renewed euro crisis.

[Not necessarily right away!]

The deflation bogeyman is just that - a myth - used by politicians and central
bankers to fear monger the masses into allowing it to inflate. It has never
been anything more.

Irving Fisher was one of the earliest authors of the debt-deflation-delusion,
and it was he who lobbied for creation of the Fed, and advised the subsequent
abandonment of the gold standard.

Clearly the ECB is solidifying his legacy.

But as far as the velocity of money goes, let's defer to Hazlitt,

"Monetary theory would gain immensely if the concept of an independent
or causal velocity of circulation were completely abandoned. The valuation
approach, and the cash holdings approach, are sufficient to explain the
problems involved.

Editor's Note: Don't miss Ed's incisive analysis found in the TDV
Newsletter three times each month, where you'll find Austrian analysis
on the economic topic which affect you today.

Ed Bugos, with a strong background in Austrian economics, is one of the world's
most sought after and respected mining analysts. Based out of the global epicenter
for gold mining exploration and financing, Vancouver, Canada, he has been
writing publicly since the late '90s and is a well known critic of government
interventions, central banking and the Federal Reserve since 2000, starting
as the original contributing editor for Safehaven.com.
Ed founded goldenbar.com in 2001, a website publishing his gold & currency
digest portending the collapse of the strong dollar policy and the rise of
the secular bull market in gold and commodities. He was one of the first to
make the call for $2,000 gold (he now is calling for $5,000-$10,000 gold),
back when it was still struggling with $300 per ounce and it was a sin to
own it.